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NAW News

Taxes

- June 2011

The passage of the tax bill in December has finally taken off the table – for at least a year or two – the seemingly endless debate on what to do about the expiring Bush-era tax cuts, Congress and the business community have turned their attention to other tax issues, including broad-based tax reform.

Starting the tax reform conversation, the Obama-appointed National Commission on Fiscal Responsibility and Reform (Deficit Reduction Commission), in its December report to the President, called for a significant reduction in corporate and individual income tax rates coupled with reduction or elimination of the “tax expenditures” – preferences and deductions – that clutter and confuse the tax code

In principle, tax reform is a worthy goal. However, there is a growing division between domestic companies that pay an effective corporate income tax rate at or above the marginal 35% rate, and the large multi-national firms that have been able to significantly reduce their U.S. taxes through use of preferences in the tax code (many of which they lobbied to have included in the code), especially foreign tax credits and deferral of taxes on their foreign income. According to an April, 2010 Forbes article on “What the Top 25 U.S. Companies Pay in Taxes” both GE and Bank of America paid no U.S. corporate income taxes in 2009, while many others paid far less than the statutory 35% rate (e.g., Ford, 2.3%; Hewlett Packard, 18.6%, Verizon, 10.5%). GE has gotten some additional recent unwelcome attention with reports that the company again paid no U.S. income taxes in 2010, in fact earning a several billion dollar U.S. tax credit, despite more than $5 billion in U.S. earnings. The current attention to GE’s tax position is noteworthy in particular because of President Obama’s appointment of GE CEO Jeffrey Immelt to chair his council on jobs and competitiveness.

With large, multi-national firms reducing or eliminating their U.S. corporate liability, the mostly domestic companies – and most wholesaler-distributors – are bearing a disproportionate share of the U.S. corporate tax burden. Therefore real tax reform that lowers rates and broadens the tax base would be welcome.

But, as always, the devil is in the details.

For example, the President’s Commission calls for repeal of LIFO. As we all know, LIFO is not a tax preference, it is a means of valuing inventory that achieves the same purpose as FIFO – most closely matching cost of goods sold with cost of replacement inventory. We would aggressively oppose inclusion of LIFO as a tax preference to be repealed.

Also, there is increasing mention of the inclusion of a Value Added Tax (VAT) as part of reform; a tax that NAW and its coalition partners have consistently opposed.

C corporations vs. pass-through businesses (added June 2011):

Also critical to the discussion of tax reform is the question of whether we should tackle reform of just corporate income taxes, or of both the individual and corporate tax code. This is of immense importance to the business community because of the growing predominance of Subchapter S Corporations and other “pass-through” entities (i.e., partnerships, sole proprietorships, and limited liability corporations) in the economy today.

Pass-through entities, of course, do not pay corporate income taxes, but pass their earnings through to their shareholders, owners, partners, etc., who then pay taxes on those earnings on their individual tax returns. And pass-through entities are growing at a pace that far outstrips traditional C corporations. According to a September, 2010 “Special Report” from the Tax Foundation, “. . . the number of traditional C-corporations declined steadily from 2.2 million to 1.9 million between 1980 and 2007. Meanwhile the number of pass-through businesses nearly tripled, from roughly 10.9 million to more than 30 million. The number of sole proprietors grew from 8.9 million to more than 23 million, and the number of S-corporations and partnerships (which include LLCs) grew at a faster rate from 1.9 million to more than 7 million. These alternatives to the C-corp have continued to grow at such a rapid rate that there are now three and one-half times as many pass-through firms as traditional corporations.”

And according to a study completed just this past April by Ernst and Young, in 2008 pass-through entities comprised nearly 95 percent of all businesses, and employed 54 percent of the private sector workforce in 2008.

If only the corporate tax code is reformed with a significant reduction in corporate income tax rates and elimination of deductions and preferences, the result could well be a more level playing field and even-handed corporate tax policy, although inevitably some corporations would end up owing more taxes and some less.

However, if the individual tax code is not reformed at the same time, the impact on the millions of mostly-small pass-through entities could be devastating. These businesses would lose the deductions and preferences that would be eliminated through the corporate reform, but would not have a compensating reduction in their marginal tax rates. In fact, under the proposals in the Obama budget, the top marginal tax rate would rise to 39.6 percent in 2012, with an additional 3.8% Medicare tax on upper income earners, PLUS a .9 percent Medicare payroll surcharge on the UNEARNED income of those upper income earners. In other words, if the corporate income tax code is reformed and the individual code is not, pass-through entities would lose some or all of their traditional business deductions and pay a marginal tax rate of more than 42% on a significantly greater amount of their income.

The President’s Deficit Reduction Commission included recommendations for both corporate and individual tax reform, but the President and Treasury Secretary Geithner have argued for reform of only corporate income taxes. Moreover, Secretary Geithner has made several comments suggesting that his department may consider reviewing whether S Corporations and other pass-through entities should continue to be permitted in the tax code. And at a meeting with business executives in mid-June, Obama Chief of Staff Bill Daley, according to a June 17th story in the Washington Post, seemed to reaffirm the Administration’s commitment to corporate-only tax reform when he commented on lowering the corporate income tax rate, then added a warning that some small businesses might face a tax increase.

Fortunately for the small business and pass-through community, the Chairman of the House Ways and Means Committee and several prominent members of both his committee and the Senate Finance Committee clearly understand the impact on the economy, and especially on the small business community, of a corporate-only tax reform effort, and have committed to pursuing reform of the individual code at the same time.

Tax reform and deficit reduction:

Finally, tax reform should be advanced as a way to lower rates and broaden the tax base, not as means to increase federal revenue to feed government’s insatiable appetite. Previously enacted reform measures, the Reagan reforms of 1981 and the significant tax reform enacted in 1986, were designed to be “revenue neutral” – to raise the same amount of revenue but create a more even-handed and fair system.

President Obama’s Deficit Reduction Commission, on the other hand, proposed broad reform as a major tax increase to raise revenue, not as a means to achieve a fairer and simpler tax code. In fact, according to a public letter released in December by Americans for Tax Reform, the report “contains a ten-year net tax hike of over $1 trillion and increases tax revenues from their historical 18 percent of GDP to a record and permanent 21 percent.”

The very language of the report is troubling: referring to provisions of the code that reduce taxes as “tax expenditures” suggests that the revenue belongs to the government, and in effect treats tax revenues forgone the same as reductions in Federal spending. Whatever the merits of individual preferences and deductions, the money belongs first to the taxpayers, not to the government, and tax reform should not be pursued as a means to avoid cutting Federal spending.

While there is a lot of discussion of tax reform, legislation to enact it will be very complex and controversial. Both the House Ways and Means Committee and the Senate Finance Committee are holding hearings on reform, with Finance Chairman Max Baucus (D-MT) promising an almost-year-long series of hearings. While no legislation is expected in the very near term, we will be watching very carefully to see what path Congress takes on this issue.

LIFO [updated June 2011]:

As you know, LIFO repeal was included in each of the budgets the President submitted to Congress and the Deficit Reduction Commission recommended LIFO repeal in its December report to the President. Most recently, the President and Congressional Democrats have recommended that LIFO repeal be included in a debt limit extension package.

Even more troubling, in recent testimony before the House Small Business Committee, Treasury Secretary Timothy Geithner acknowledged that the Administration supports raising taxes—specifically including on some small pass-through businesses—to avoid spending cuts.

NAW member companies and the members of our NAW-led LIFO Coalition have been aggressive and effective in making the case for LIFO to critical members of the House and Senate, and we believe are largely responsible for the fact that no action has been taken on repeal legislation. The success in preventing action on repeal is a text-book case of what business can achieve when it fully engages in the legislative process.

Despite the effectiveness of the businesses that worked to defend LIFO, we remain very concerned about possible repeal. In anticipation of the possibility that major tax reform might be considered in this Congress, the LIFO Coalition has resumed our grass-roots effort, especially with almost 100 newly-elected members of the House and Senate who are unlikely to be very familiar with the issue. As a note aside, the election of Wisconsin Republican businessman Ron Johnson literally doubles the number of accountants serving in the U.S. Senate (the other is Senator Mike Enzi of Wyoming); ensuring that at least two senators will thoroughly understand the LIFO issue.

We also continue to monitor the activity at the Securities and Exchange Commission (SEC) as they move toward a decision on convergence of U.S.GAAP with the International Financial Reporting Standards (IFRS), although recent actions and statements suggest that the convergence to IFRS may no longer be the high priority it once was for the SEC or International Financial Standards Board. As the prospect of SEC action becomes less certain, pressure on Congress to act on repeal in anticipation of that action is alleviated.

Despite the mixed signals on convergence, Coalition leaders met last year with the Chief Accountant and several Deputy Accountants at the SEC to discuss possible regulatory actions to address the “conformity” requirement that would threaten LIFO if the SEC were to move to IFRS. We subsequently met with several staff members at the U.S. Treasury Department’s Office of Tax Policy, and finally with the Assistant Secretary of Treasury for tax policy. The need for immediate regulatory action to deal with the conformity issue was mitigated by signals that the move toward convergence has lost intensity, but we will continue to closely monitor the situation.